The Estimated Tax Penalty
You need to pay in at least enough tax through a combination of withholding and estimated payments to avoid the estimated tax penalty. To avoid the penalty, you will need to pay in "at least 90% of the tax for the current year, or 100% of the tax shown on the return for the prior year, whichever is smaller," according to the IRS.The penalty is basically the IRS's way of charging you interest for not paying your taxes throughout the year. The current interest rate for underpayments by individuals is 4%. (The IRS sets this rate each quarter.)
Figuring out how much to pay in estimated taxes
The easiest method for calculating your estimated payments is to divide last year's unfunded tax liability in four, and then make estimated payments using this figure. To do this, look on last year's tax return and find your total tax liability . Then subtract any withholding you expect to pay in for this year. If your withholding will be about the same as last year, you could subtract last year's withholding amount. The difference is the amount of tax that needs to be paid in through estimated taxes to avoid a penalty.This method, while quick and easy to calculate, does not take into account changes in your income for this year. You might have more income, or more losses, or qualify for different tax deductions. The alternate method that I use personally and with my clients is to run a tax calculation based on this year's income.
What I do is run a report showing income and deductions for the year using a financial software program such as Quicken, Microsoft Money, Quickbooks or Peachtree. These programs can generate a report showing your income and deductions for the year-to-date (or any other time period you want to measure). I then export the figures into a spreadsheet program for further number crunching. Be sure to multiply these year-to-date amounts to cover the entire year. To make the math easier, you may want to run the report based on, the first half of the year, for example, and then you could multiply by two to get a projected full year figures.
Using these annualized income and deduction figures, you will calculate your projected tax liability. You will need to know the current year's tax rates. And you would subtract any withholding or tax credits you will be eligible for in order to find out exactly how much needs to be paid in through estimated tax payments.
To help keep track of these tax calculations, the IRS has a worksheet available with Form 1040-ES (pdf). This worksheet will help you calculate the minimum amount of estimated tax you should pay to avoid the penalty. The worksheet also includes all of the current year figures for standard deductions and tax rates, to help you obtain an accurate figure for this year's estimated payments. (Here's a sample estimated tax calculation so you can see the sort of math involved.)
After setting up your own spreadsheet, be sure to save it for future reference. Once the spreadsheet is set up, you can use it again to get a more accurate projection of your tax liability later in the year. And then you will be able to adjust your estimated payments so you pay in just the right amount.
Estimated tax payments are due quarterly. Here's a list of the payment due dates.
